Corporations have multiple options to fund themselves. Depending on availability there is a hierarchy of choices that range from the cheap to the expensive.
Entrepreneurs start companies with personal capital. That’s the cheapest capital available in that it allows founders to retain all of the equity in the business. If that capital is not enough, the entrepreneur will turn to friends and family.
This is also inexpensive in that friends and family are more willing to help the entrepreneur get the business off the ground. They are less demanding for returns and will usually take less equity in return for the investment.
After friends and family the business owner can borrow money or they can exchange ownership for outside capital. If they go the equity route they can turn to venture capital funds or angel investors.
This option is attractive in that while equity is an expensive way to finance a business, it is less risky. Debt options at this stage in the life of a company may be attractive if loan rates are low.
The problem is that debt in the early stages is usually only available with personal guarantees and collateral. If the company stumbles and fails to pay, you pay. Though rates are low enough to entice borrowing, a misstep can be quite costly.
If the business succeeds, the next option for raising capital is the public equity markets. If the company was funded with venture capital, it is an almost certainty that the business will offer equity to the public.
Doing so is a way for the venture capitalist to monetize its investment in the company. Apparently taking its share of profits in the form of dividends or mandatory distributions are not enough, but I digress.
As a seasoned publicly traded company the business will usually turn to debt for its remaining capital needs. The debt markets comply, assuming that with sufficient equity in place, lenders are protected.
Over time the pool of available capital in the debt market increased substantially for public companies. That large increase in available funds made it easy for businesses to fund many of its needs with readily available debt.
This borrowing or leverage helped equity stakeholders immensely and returns were greater as a result. In many ways, companies became intoxicated with using debt instead of the more expensive equity.
For many years using debt became commonplace. Even the disastrous experience with junk bonds in the late 1980’s could not deter companies from seeking this quick, cheap and readily available form of capital. As long as cash was flowing companies could load up on debt without worry.
Corporations then were not all that different from consumers who loaded up on real estate backed debt to fund living expenses or to upgrade living conditions. Mortgages were being handed out like candy to a baby.
The same is true of corporate debt markets. We all know how the real estate debt market crashed. Will the corporate debt market be the next shoe to drop?
Well, if you dig past the headlines of the market hype regarding the current collapse in stock values, you will find plenty of investors that are quite concerned about debt coming due for many corporations.
The credit market is frozen and nobody is lending. You may have heard stories about home buyers with the strong credit and large down payments having difficulty obtaining financing. The same can be said of companies with debt coming due over the next twelve months or more.
No matter the quality of the company, if millions or billions of dollars in debt cannot be refinanced when due, corporations may be forced into bankruptcy. In that event the common stock holder would be left holding the bag.
If debt holders are not paid, they usually end up owning the entire company in any reorganization. Common stockholders have the lowest priority in liquidation. As such maybe using debt over equity was a bad idea after all.
Value investors avoid companies with large amounts of debt on the balance sheet for a reason. In a worst case scenario companies with huge debt loads can collapse no matter the soundness of the underlying business.
What is transpiring today is directly correlated to this dynamic. Stocks are lower because many companies are facing the very real possibility that debts coming due will not be repaid or refinanced.
There is a ticking time bomb out there and very little is being said about it. Yes, one can argue that stocks are oversold at the moment, but in some ways what is transpiring is very Rational.
If you want to avoid the debt bomb I would suggest perusing the balance sheet of stocks in your portfolio. If there is debt coming due, you may want to consider your options. At a minimum understand what is happening before the bomb goes off.
This article was written by Jamie Dlugosch, contributor to InvestorPlace.com. For more actionable insight like this, go to: www.InvestorPlace.com and check out:
